November 24, 2015

Market may be in for trouble

Healthy bull markets have broad participation, but unhealthy ones have narrowing participation.

Here's a look at both the technical and fundamental issues that I see facing stocks:

The Technicals: The Rally Has Bad Breadth
The best gauges of market breadth are the advance/decline line and the number of stocks hitting new 52-week highs. 

Strong bull markets exhibit bold cumulative advance/decline lines and expanding 52-week highs, which confirm the highs reached in the broad indices (where large-capitalization stocks dominate). But weak bull markets show breadth that diverges from the big indices on these two measures, failing to confirm the new highs.

To measure this accurately, analysts often look at the relationship between an index's equal-weighted and capitalization-weighted versions. A rising relative line between the two denotes a healthy market, while a declining line means a few large-cap stocks are driving the advance.

This year, the New York Stock Exchange's common-stock-only advance/decline line peaked in May and lagged during the market's recovery from late-September lows.

Moreover, new NYSE 52-week lows have eclipsed new 52-week new highs for some time.... This is a signpost of underlying weakness:

We can also clearly see a declining trend if we compare the S&P 500's equal-weighted and cap-weighted versions. This shows that the index's large-cap components have outperforming their smaller brethren since mid-April -- and remarkably, still made new lows in the face of a 12% recovery in the overall S&P 500:

This raises the question of whether investors should chase the FANGs or the NOSH -- Nike, (NKE), O'Reilly Automotive (ORLY), Starbucks (SBUX) and Home Depot (HD). These stocks could eventually get defanged because the rest of the market might be unusually vulnerable to a correction.

Large-cap quality holdings might work for a longer time. But without support from the majority of lesser stocks, attrition seems likely to eventually take a toll on the market's current leaders. As the old saying about Wall Street's traditional "Santa Claus Rally" goes: "If Santa Claus should fail to call, bears may come to Broad & Wall."

The Fundamentals:  Good News is Great, Bad News Is Even Better?

The fundamental front shows concerns about punk domestic economic data, as seen in weak retail sales, a manufacturing contraction and a possible peak in housing and autos. We also see the prospects for moderating operating profits, slowing Chinese and Eurozone growth rates and a new multiyear low in high-yield bond prices.

On that last point, high-yield bonds are definitely acting "junky." CCC-rated bonds have underperformed BBs over the last 12 months by 700 basis points (and by over 450 basis points ex-energy). There are only three previous instances of such deep underperformance. Two coincide with the mature credit cycles of early 2000 and early 2008 and one was a "false positive" in late 2011.

On the point of slowing global economic growth, Goldman Sachs recently opined that the U.S. economy's natural state has deteriorated from the past and "will remain lower for longer." Indeed, some seven years of monetary easing have served to weaken the economy to the point where secular-growth prospects might be nearly half of what we experienced over the last three to five decades.

Deutsche Bank goes one step further, arguing that after decades of bubbles, reducing the equilibrium real rate of federal funds serves as a negative to growth:

"The real case for policy error -- equilibrium short real rates may be below zero. There are two interpretations of the macroeconomic data that have vastly different implications for the effect of imminent rate hikes. The first is the 'conventional' view, which the Fed subscribes to. This view posits that the short-term real equilibrium rate is around zero. Since the nominal funds rate is at the zero lower bound, policy is accommodative, and this is why the labor market has improved rapidly. Inflation has not picked up because it as a lagging indicator. ...
The alternative view is more worrying. In this view, the equilibrium nominal rate is at present much lower than the Fed thinks, and the equilibrium real rate is meaningfully negative. Policy at present is not very accommodative, and to the extent that it is, inflation is actually running above its equilibrium level, which is close to 1%. ...
This is the important policy-error scenario, because even a very shallow path of rate hikes might drive the real fed funds rate well above the short-term equilibrium real rate, further depressing demand. It is then plausible that the economy would be driven into recession, and the Fed would quickly be forced to abort the hiking cycle."
-- Dominic Konstam, Deutsche Bank

Moreover, there is simply too much debt. Unconventional monetary policy simply expands the debt load and  makes the U.S. economy extremely vulnerable to an interest-rate hike. So, the Fed is trapped.

Meanwhile, the conspicuous flattening in the yield curve is another possible signpost of slowing domestic economic growth and/or a Fed policy error:

The Calm Before the Storm
The bottom line: The "Ah-Ha" Moment, where investors lose faith in central bankers, might be ever closer at hand. Both the technical's and fundamentals are conspiring to form a possible toxic market cocktail.